May 29, 2015
The Most Important Metric For
Finding World-Class Stocks
By Dave Forest
In April 2015, I recommended that my Top 10 Stocks readers buy Kraft Foods (Nasdaq: KRFT).
Within 24 hours of my recommendation, the company received a takeover offer from The H. J. Heinz Company -- backed by legendary investor Warren Buffett's Berkshire Hathaway and Brazilian private equity giant 3G Capital.
Powered by this top-tier endorsement as well as a considerable premium to market on the offer, Kraft soared 45% in two weeks following my recommendation. It was one of the most dramatic wins I've ever had the pleasure to be involved with.
But the truth is that my readers and I nearly missed out on the opportunity. Fortunately I paid attention to the right metrics. The fact is, the timing of my investment was complete serendipity. I had no inkling that a buyout was on tap for Kraft. Had I waited 24 hours to release my April issue, we would have missed the stock's double-digit bounce entirely.
But looking back, there were a number of indicators -- some of which were downright glaring -- that showed Kraft was ripe for this kind of lavish attention.
One in particular was the geography of the company's sales, which are 80% concentrated in the United States. It's a critical advantage because foreign currency exchange rates against the dollar have been wreaking havoc the past year on firms that sell abroad.
That was a good enough reason to like the company, but there was another variable that was even more vital in setting up the opportunity with Kraft.
Why It's Critical To Look At The Right Numbers
Kraft was an enigma when it came to financials.
Just before the firm's billion-dollar buyout announcement, a look at a go-to source like Morningstar would have revealed conflicting information.
On the one hand, the company traded at a fairly hefty price-to-earnings (P/E) multiple of 30. That's well above the S&P average of 19.
Based on that metric, the stock looked fully-valued -- if not somewhat overpriced. But at the same time, other numbers showed that the firm was undervalued.
So what was going on?
It all came down to cash flow.
The truth is that earnings figures can be quite subjective. In Kraft's case, the value of the company's pension portfolio had been recently readjusted. This resulted in $1.3 billion worth of cash charges in 2014, leading to a direct 55% reduction in earnings.
But in reality, these charges had no effect on the cash actually coming into the company.
To see that fact, you had to delve into the Kraft's financial statements and look at the company's cash flow numbers.
When considering those figures, the company's performance was substantially better than the P/E ratio suggested. The chart below shows how earnings may have looked dour, but yet cash flows were actually solid.
All told, Kraft's cash flows were actually level in 2014 compared with the previous year -- even as earnings fell by 61.6%. This fact fooled most investors, but it grabbed the attention of keen-eyed investors like Buffett.
Recently, I applied this same approach to find another stock that has many similarities to Kraft.
Now, out of fairness to my paid subscribers, I can't reveal the company's name and ticker symbol. But I can tell you a little bit about it...
You see, where Kraft owned some of the most recognizable names in the food business -- Oscar Mayer, Planters and Maxwell House -- this firm holds an equivalently critical share of the women's apparel industry.
That kind of stranglehold on a market is exactly the sort of advantage I look for in my premium newsletter, Top 10 Stocks.
Like Kraft, the firm derives more than 90% of its sales and profits in the United States. And though it achieved record-high earnings in 2014, new investors have shied away from the stock because of its high P/E ratio -- again, like Kraft.
In actuality, the company's net cash flow has never been higher.
And while I don't expect Buffett to take over this firm as well (and create huge gains in short order), I think this is an investment that will grow for some time -- one to own for the long haul.
For me, the main takeaway from the Kraft experience is that it's important to always look at the right numbers and make your own judgments when researching a potential investment. You can't simply look at a P/E ratio on a website -- the way most investors do today.
Proper research and analysis takes more work, to be sure. But that's what's required to find profitable opportunities. There are no free lunches.
Good investing,
Dave Forest
Chief Investment Strategist
Top 10 Stocks
Editors Note: One of the easiest ways to create wealth for the long haul is to buy shares of fantastic businesses at a reasonable price. Buffett has said this for years, yet too few investors actually follow this advice. That's why Dave spends his days researching the world's greatest businesses and telling his Top 10 Stocks readers about them each month. He recently published his findings on some favorite investments in a report, "The Top 10 Stocks For The Next 12 Months." To get the names and ticker symbols of some of these stocks, here.
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